chapter 17: sh litigation - wake forest...

BusOrgs – Palmiter (Fall 2012) Module VII (Chapter 17, 18, 19, 20)

Anna Dowdy

Chapter 17: SH Litigation

I. SH LitigationA. Derivative v. direct actions1. Derivative actions: 2 suits in 1—enforce fiduciary duties to Ca. Enforce duties to Cb. SH (lawyer) –> C –> Fiduciariesc. Can be brought against 3d parties (i.e. suppliers) but very rare b/c normally up to BOD to

decide whether to bring suitd. Ct Order to sue the BOD’s own memberse. Look at statute: “on behalf of the C” if the C gets any recovery(1) Value to SH: increases share value, so in public C, depends on % of shares held by SH(a) Really, the lawyer is the one who benefits from legal fees paid by C(b) if suit is allowed to go forward, then the atty is acting on behalf of the C and will be paid

if successful(2) Del. Supreme Ct: the SH must(a) retain ownership of the shares throughout litigation; (b) make pre-suit demand on the BOD; and(c) obtain ct approval of any settlement. i) B/c binds C, thus affecting uninvolved SH2. Direct action: representative suit—protect SH rightsa. Class action(1) personal injury to SH themselves, not an injury to C(2) bring as class b/c individually not cost-effective to bring suit(3) atty’s fees usually % of recovery(4) acting “on behalf of class”(5) bring suit for violation of direct duties w/ recovery going to SH directly(6) avoid demand requirement (avoid dismissal option by BOD)b. SH only get pro rata portion of recovery3. Distinction btw two: who recovers?B. Demand requirement1. BOD as arbiter of lawsuit’s merits2. Aronson test: (1) D disinterest and independence; (2) decision protected by BJRC. Special Litigation Committee1. Judicial review: BJR or more?2. MBCA: universal demand + BOD dismissalD. Pl. Standing1. Adequacy2. Contemporaneous w/ ownershipE. Policy Issues


1. Who guards the guards?a. Don’t trust individual D or SH or Ct or investment firms2. Challenge of settlements (what are the stds for settlement? Is court aware of parties that

settled out?)3. Nature of atty’s fees

II. SH Self-protection (Prof. Robert Thompson)A. Vote1. Approve fund transactions2. Elect D (annually, special meetings)3. Remove D / fill vacancies4. Initiate action (amend bylaws, adopt resolutions)B. Sue 1. Enforce fiduciary duties owed to C (derivative suit)2. Protect rights (disclosure, voting, appraisal, inspection) (direct rights)C. Sell1. Liquidity (except insider trading)a. Largely a matter of federal law but hinges on fiduciary duties2. Takeovers (tender offer)

III. Fiduciary Duties (D, Controlling SH)A. SH LitigationB. BOD decision makingC. BOD oversightD. D self-dealing (conflicts)E. Executive CompensationF. Duties w/in C groups1. M&As btw P and S

IV. Tooley v. Donaldson (Del. 2004)A. Brought direct suit against C through its BOD has violated fiduciary duties to C and SH

by postponing merger.B. Should this be a direct or derivative action?1. Old appr was unclear so goes to Del. Supreme Ct. (Special injuries)a. Special injuries: individual injury is different from injuries suffered generally(1) too narrow2. New appr: turns solely on two questions:a. Who suffered the alleged harm?(1) C: derivative(2) SH: directb. Who would receive the benefit of any recovery or other remedy?(1) C: derivative(2) SH: direct


C. Some fiduciary duties are owed in such a way that SH may bring direct suitD. Held: neither direct (SH claims not yet ripe) or derivative (no injury to C)1. Would be direct if SH waited until actually injured

Derivative Direct

vindicate C interest or right vindicate SH rights; may vary from SH to SH

any recovery goes to C individual SH recovery

demand requirements: unless SH can show that demand would be futile (Del. only, MBCA has no such provision)*making demand in Del. essentially kills the lawsuit

class-certification requirement (typical SH, SH will be adequate representative)

ownership requirements don’t trust anyone when settling

any settlement be ct-approved (thus SH cannot seek to be bought-out b/c not in C’s interests)

ask: Who is really making the claim? Who will recovery go to?

I. HyposA. BOD issues new stock, but denies preemptive rights to existing SH. SH sues.1. Direct—whole class of SH injured2. Preemptive rights: BOD issues dilutive share issuance, and SH asks for protectionB. P refuses to allocate business opportunities to partially owned S. SH of S sues P.1. Derivative—b/c recovery would go to S2. SH is seeking to vindicate a right of S that has been excluded, so S as a C is being

harmedC. BOD grants CEO a lifetime employment K. SH sues.1. Derivative—any recovery goes to BOD2. Direct—contrary to fundamental duties of BOD; unauthorized use of BOD’s power (ultra

vires) such that each SH is denied the promise of central BOD power3. It’s both, so consider which party will obtain more damages; SH gets to pick which way

to sue

II. Demand RequirementA. See Rule 23.1(b)(3) Derivative Actions1. State w/ particularity: (A) any effort by Pl to obtain the desired action from the Ds or

comparable authority and, if necessary, from the SH or members; and (B) the reasons for not obtaining the action or not making an effort

B. Is demand req procedural or substantive?


1. Filters out by procedure claims that should not be brought (extortion-type cases)2. Substantive b/c rule identifies a relationship btw SH and C; will not allow SH to speak

for C until SH proves its bonafide-ness and interest in CC. Aronson v. Lewis (Del. 1984)1. CEO Fink gets a stellar retirement package for life from C2. Aronson is another D3. SH Lewis brings suit for breach of fiduciary duties to Ca. Any recovery would go to C b/c C was injured by retirement package, not individual SH4. Must plead particularized facts (pleading rule) that create strong inference that:a. Ds were not independent/disinterestedb. The transaction is not protected by BJR(1) tainted BOD(2) fundamental underlying decision not covered by BJR5. Did Fink dominate the BOD such that BOD was not independent? NO.a. See Del. 141a: business and affairs of C is delegated to BOD(1) presumption of validity under BJR6. Held: BOD not so tainted that it could nto hear a demand; transaction not so awful that it

violates BJR7. Takeaway: Get particularized facts by exercising inspection rights before suing

III. Quiz (slide 16, ch.17)A. Fink dominated...FALSEB. SH can avoid...FALSEC. Fink’s deal...FALSED. Despite academic claims...FALSEE. Whether a lawsuit...FALSE

IV. BOD Request for DismissalA. Derivative suit1. Special Litigation Committee (SLC) set up by BOD to determine when to bring suita. Ok in some circumstancesb. Cleanses the BODc. Does not preclude SH from bringing suit—can challenge SLC(1) demand futility(2) Del.: When confronted w/ SLC request for dismissal: (a) 1st: inquire into independence and GF of the SLC and the bases for its conclusion(b) 2d: balance btw C and SH interests; ct should determine applying own independent BJ

whether to dismissi) akin to language in Wilkesii) as intrusive as C law gets in Del.(3) MBCA appr: (a) 7.42(1)&(2) Demand(b) SH must always make a demand, even if futile


i) may accelerate 90-day irreparable injury to C would result by waiting 90 days(c) 7.44 Dismissali) SLC/majority Ds/etc. have power to request dismissal, which shall be granted by ct

DEMANDDelaware - 3 options MBCA - 1 option

#1 optionmake a demand on BOD(treated as a concession that BOD is disinterested and could take action; thus, cannot make demand then bring suit)

SH must make demand on BOD in all cases—demand is never futile; then must wait 90 days for BOD to resolve demand; then may file suit in ct

#2 option:or bring lawsuit in ct (derivative) w/o making a demand; so suit is that (1) demand is futile; (2) underlying claim

SH can argue that 90 days is too long (irreparable injury to C) such that ct will accelerate waiting period

#3 option:SLC established by BOD is a “third option” and urges ct to dismiss when SH brings suit. Ct will look at: (1) SLC composition + process was reasonably clean and properly conducted; (2) independent business jment: after ct decides that SLC is sufficiently clean, judge can exercise its own IBJ and decide whether case should go forward

BOD, after suit filed, BOD can argue that it is independent and request dismissal

or can set up SLC and have them argue same thing...

Before ct dismisses, it will look at case law factors (about 7 from Wisconsin case)

Who should speak for the C? SH, BOD, or Ct?


Chapter 18: BOD DECISION-MAKING

I. BJRA. Both procedural (how cases come to ct; where demand req. comes from) and

substantive (id’s what a Pl. must show substantively to overcome this presumption—that BOD is acting in GF, w/o illegality, properly informed, w/o a conflicting self-interest)1. Off the hook until Pl. shows that BJR does not apply b/c BF, illegality,

self-dealing, or lack of informationB. Rule v. Doctrine

1. BJR: not going to hold Ds personally liable2. Business Jment Doctrine (BJD): will not question BOD’s decision and not

hold Ds individually liableC. Shlensky v. Wrigley : judicial abstention

1. Application of BJD2. BOD not required to “run the numbers” on every decision3. Pl alleges arbitrary and capricious mismanagement, and failure to exercise

reasonable care, of C affairs4. D responds that ct will not step in and interfere w/ honest BJ unless there

is fraud, illegality, or conflict of interest5. Ct: grants D’s motion to dismiss

a. No fraud, illegality, conflict so assume that BOD is making a justified decision

b. There is a rational basis for the BOD’s decision(1) Ct argues sua sponte that surrounding neighborhoods

would be hurt by nighttime baseball (decrease property value)

(2) no evidence of increased profit(3) thus, outliers are allowed

D. Reasons for BJRE. Exceptions to rule: fraud, illegality, conflicts (and waste/gross negligence)

II. Informed Decision-makingA. Smith v. Van Gorkom

1. Background of case: company situations2. Surprising result—explain?

B. Causation & reliance

III. Avoiding D LiabilityA. Exculpation Section 102b7B. Indemnification: mandatory/permissiveC. D&O insurance (who pays?)


Dawn LeeNOTES- 11/26/12

- Board decision Making o Timeline

1977- Wrigley dies, one deathbed= “never sell” 1981- son sells team to chi. Tribune 1988- Chi. Ordinance banning night baseball overturned August 9th= first night game

- BJR o 2 prongs:

Procedural Substantive

Conflict of interest (COI) Illegal Fraud Waste Inattentive- Standard in DGCL= Gross Neg.

- Smith v. Van Gorkamo Tax problem

Not sufficient capital income Revenues- depreciation= NOT enough taxable income for

investment tax credits to be useful EITC- Earned income tax credit

o Problems/solutions: Revenues= Biz is good Cash flow= could handle more debt Tax deductions= too high Taxable income= too low Invest. Tax credits= cannot use

o Solutions Get congress to pay for unused tax credits Acquire biz to generate tax. Income Sell to public corp that wants tax benefit Sell to private corp that wants tax benefit


Sell In mgmt. buyout (mgmt. borrows to buy corp)- doesn’t create taxable income

o Events: Van Gorkom tells the Bd that there’s an offer of 50% premium on all

shares 62% better than average SH price over the year Had a deadline of tomorrow- if it gets out, the price of shares will

immediately go up Pritzker wanted a stock lock up of 1.75 mil shares Stock lockup= option on shares

o How did bd fail? 4 ceos and 1 academic Bd did NOT inform themselves of Van Gorkam’s role Pritzker had steamrolled Van Gorkam- VG was a fool who got taken by

Pritzker MBO would got for $55 or 60 There WAS a test market to determine if the price was a good one 2 other entities said the price was TOO rich GE and KKR showed interest but backed off Bd didn’t deliberate long enough

o Rule Standard= Gross Negligence Directors did NOT adequately inform themselves of:

VG’s role in sale Intrinsic value of company Details of deal (2 hour meeting without prior notice and no crisis)

BJR deference to Bd: Premium was a great price Test market showed good price Collective experience of Dirs was high Boston consulting firm said good price



- Group question- what did the Van Gorkom case mean?o Answers by groups

Judicial second guessing New board procedures New role for outside directors Court reacts to “fast shuffle” DE is acting in a way that no other state does (finds no precedent in DE

law) o Recommendations by groups

Do nothing- let DE courts fashion director liability rules Codify VG- directors liable for gross negligence Overturn VG- directors not liable for gross negligence- BJR New law- higher standard of independence and reasonableness New law- director liability depends on level of participation New law- safe harbor for following boardroom process New law- directors (SHs) can contract for exculpation

- Avoiding director liability (generally) o How do directors (especially in public corp) have assurance that their service on

the board isn’t going to expose their personal assets to harm? Proximate cause (tort) BJR Exculpation clause

Provisions in articles authorized by statute Indemnification

Statutory Agents have this by common law

D&O (director & officer) insurance o Jim Hanks

Nothing in the history of corp law suggests that personal assets of directors were intended to constitute a financial safety net for SH

Actually not quite true, look to history of banks However, has become true over time

o Director’s personal assets are not a financial safety net


o BJR and Causation Trans Union

Even if the directors had been property attentive would they have necessarily gotten a better price?

o Unclear that that would have happenedo Traditional proximate cause rules- Π must show that

failure to do something would have caused harm In this case, it would be difficult that if the directors

had acted differently, they would have gotten a better price

What’s the harm they caused? Barnes v. Andrews (SDNY 1924)- Learned Hand

o Proximate cause requirement in director liability Π must show that the business would have failed

otherwise Francis v. United Jersey Bank (NJ 1981)

o Can a director who doesn’t pay attention to her duties (drinking, not doing her duties) be held liable?- yes, had she been paying attention, she would have expose that her sons were stealing from the corp

DE- burden shifts to Δ

o Exculpation DGCL § 102 (statute was meant to overrule TransUnion)

(b) certificate of incorp may also containo (7) provision eliminating or limiting personal liability of

director (i) breach of director’s duty of loyalty (ii) acts or omissions not in good faith or which

involve intentional misconduct or knowing violation of law

(iii) under § 174 of this title (iv) transaction for which director derived

improper personal benefit Generally, SHs have agreed to put in these exculpation provisions in

public corp


Event study- Bradley & Schiapani, 75 Iowa 1 (1989) Trans Union had no statistical effect on DE corp stock prices

(market prices) After Trans Union, D&O premiums increased After DE’s adoption of § 102(b)(7) (exculpation provisions), DE’s

corps are worth less than other corp (minus 2.67%)o Cost DE SHs 3.2% returns

If corp has exculpation clause In a motion to dismiss, based on the clause, court will dismiss- lack

due care

o Indemnification Could the directors in Trans Union have insisted that corp indemnify

them?- yes NCBCA

Mandatory indemnification o Unless limited by its articles, a corp shall indemnify a

director who was successful on the merits or otherwise Authority to indemnify

o Corp may indemnify if (1) conducted himself in good faith (2) reasonably believed that his conduct was in

the corp’s best interesto Corp may not indemnify

(1) in connection with a proceeding in the right of the corp (derivative suit)

o D&O Insurance All modern statutes allow for the corp to pay for D&O insurance NCBCA

Corp may purchase and maintain insurance on behalf of director whether or not the corp would have power to indemnify

o Any person deciding to be on a BOD should be asking about indemnification provisions, D&O insurance, exculpation clauses, and proximate cause rules for the state



- Assurance that if you join a board (especially public corp) that you will not have to risk your personal assets

o DE Proximate cause requirement Π does not have the burden, becomes a burden for the Δ

o DE GCL102(b)(7)- Exculpation Exceptions Breach of loyalty Bad faith Violation of legal capital rules Improper personal benefit

o Indemnification In most statutes you can have an agreement with the corp so that they can

pay for the defense costs upfront Not only laid out in statute (mandatory and permissive) Typically found in bylaws

Contractual requirement beyond what is in the statutes o D&O insurance

Part of the policy in which the insurance company will pay the corp o Settlement- derivative suit

Corp will pay defense and settlement costs if the director is not judged If director is judged, then corp won’t pay (incentive for director to settle)

- Board oversight

o Director functions Expectation for directors

Aspirational standards of care- what they would like the director to do

o Standards of conduct state how you should play a role, standard of review states whether a court should impost liability, in the real world standards of review in corp law pervasively diverge from standards of conduct

Normative standards of care- point at which director will become liable if they don’t do this


Requirements to be a director Natural person (can’t be a corp, but can be a minor, doesn’t need to

be educated) Need not own stock No special expertise

o SHOULD become familiar with businesso Financial expert only for public audit committee

MBCA § 8.30 Standards of Conduct for Directors (aspirational standards)

(a) Each director SHOULD acto 1. In good faith (doing what you should be doing)o 2. In a manner the director reasonably believes to be in

the best interests of the corp (b) Directors, when becoming informed in connection with

board’s decision making or oversight, SHOULD discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances

o Looks similar to torts- reasonable person standard Duties (as a director who suspects a “red flag”)

Ask questions Options for directors who discovers a “red flag”

Resign o May make a “noisy exit”- make it clear to outsiders that

you are withdrawing from the board and here are the reasons why (under SEC statutes, avoid liability if you do this)

How would a SH react to a noisy exit? Sell stock immediately, hold (wait and see)

o Plurality of surveyed SHs do this Depends on who it is Buy more stock

o Very few SH do this If you are present at a meeting, then you are (by default rule)

deemed to have assented to the actiono Unless you object to meetingo Dissent or abstain from an action, entered into the minutes


If the minutes don’t reflect this, then must file written notice

Francis v. United Jersey Bank Suit by bankruptcy trustee on behalf of the corp (on behalf of

creditors) Reinsurance company (Pritchard & Baird, Inc.) arranged contracts

between insurance companies that wrote large policies to other companies in order to share risks

Directors were Charles Sr., his wife, and his two sons Charles, Sr. died and left his wife and sons on the board Charles, Sr. had been in the habit of taking “SH loans” from the

corp, paid back each year, after his death, his sons continued this practice but took out bigger loans (working capital deficit- were taking out more than the corp was taking in, red flag that something was wrong with the corp)

o By 1975, corp was bankrupto Wife was not involved as a director (died during the suit)

When is an “absent” director liable? (wife)o Court

What should a director do? Does not necessarily mean she’s liable (even though

she failed to do what she should have done- failure of care/oversight)

Problem- how do you know she could have made a difference, how do you know that her absence was a proximate cause of the bankruptcy

In this instance, resigning is not enough, should have sought to enjoin her sons to stop their actions (provisions available where you can ask the secretary of the state, in some instances state attorney general, where you can ask illegal actions of corp to stop, derivative suit to enjoin illegal actions)

o How should she have known to do these things?


Court expected wife to have consulted a lawyer

Wife’s neglect of duty contributed, failure to act contributed to continuation of corruption, consequently, her conduct was a substantial factor contributing to loss

Sometimes, a director may have a duty to take reasonable means to prevent illegal conduct by co-directors

Malfeasance- failure to pay attention to corrupt business decisions o Failure to pay attention is a clearer cause (causation in

malfeasance is clearer than in misfeasance), could have done something to have prevented the harm

Misfeasance- failure to pay attention to just bad business decisions o BJR protects misfeasance

Hypo Would the sons have been responsible for running the corp into the

ground just because they make foolish decisions? (lack of care)o No, BJR protects themo Is their absent mother liable?

No, proximate cause is hard to prove- her attention might not have prevented their actions



- Fiduciary duties o Procedure by which fiduciary duties are enforced

Direct actions Derivative actions

o Generally understood to be owed to the corp (sometimes, owed to SHs)o Procedure

Decisions by the board BJR

Oversight (charged with understanding the business well enough to take action)

Closed corp case- harm by insiders Illegal action

Director conflicts (conflicts of interest) Instances in which the directors make decisions, but the decisions

are corrupt Look at whether decision is fair to corp

Executive compensation (not covered in course) Controlling SHs (not covered in course) Federal law

Codified/created fiduciary duty with respect to insider trading Insider trading- generally legal

o Some instances in which this becomes illegal

- Board monitoring of illegality (with respect to oversight duties)o Important questions

When must directors react? Internal controls required? Sarbanes Oxley?

o Highly illegal activity is Criminal Socially undesirable But- profit maximizing


o DE law Graham v. Allis-Chalmers (Del 1963)

Alleging that manufacturing company is price fixing- antitrust decrees (which is beneficial to the corp- highly profitable, but also highly illegal, § 2 of Sherman Act- criminal)

Lower level management engaging in this illegal conduct After discovery

o Tools available to punish the corp (criminal penalty, civil penalty, corp criminality)

o Derivative suit brought by SH Graham Board should be responsible for paying the fine (not

the corp) Court

o What must you do as a director to ensure legal compliance? Not aware of the illegal action- then you are

exonerated and you don’t have a responsibility to discover this illegal activity

o Don’t have to have a compliance system (e.g., surveillance system- compliance office, reporting, independent review of contracts)

o Burden is not on the director to show that he was aware of the illegal activity (Π has the burden to show that the director was aware and failed to take action)

Unless it’s clear that there is something bad happening in the corp, presumption that the director is doing the right thing

Caremark (Del 1996) Eventually codified in Sarbanes Oxley Act § 404 Healthcare provider engaged in referral kickbacks (illegal under

Medicare and Medicaid) SH derivative suit against Caremark

o Board did not institute a control systemo Illegal activity- medicare fraud (very profitable to corp)


Should the Chancellor accept the light punishment in the settlement agreement? (Caremark agrees to compliance measures and pays $250 million)

Court/Chancellor Alleno Requirement that the board has a compliance system in

place (internal control compliance system- must be 100% good- aspirational standard- can’t decide how much compliance is necessary, directors can’t balance how much compliance)

Responding to changes in federal law (federalism reaction)

Expectation that directors are more liable, board is more responsible for monitoring for illegality

Federal sentencing guidelines- can have your punishment reduced if had a compliance system in place

o Πs have to show Either

1. That the directors knew, OR 2. Should have known that violations of

law were occurring (sustained and systematic failure)

In either event 3. The directors took no steps in good

faith effort to prevent or remedy that situation, AND

4. Δs to not establish affirmative defense that such failure did not proximately result in the losses complained of

o No ability of board to say that they were just trying to maximize SH wealth

o Compliance systems Did not work as well in real life (e.g., Enron) Criticism of US compliance systems

Find ways to sell to customers


Reporting to others how you’re doing your job well Not BJR (does not defer to board’s decisions for compliance systems)

Role of policing

o Interesting paradigm Duty of care/duty of loyalty

Illegal activity (looks like board is following duty of care/loyalty) o Board is completely informed that this will result in a

benefit to the corpo Completely disinterest decision

Duty of obedience Director can’t approve a decision that is illegal (even if the

decision was informed and disinterested)

o Sarbanes-Oxley § 404 (2002) Requires that a corp in its annual report to contain an “internal

control report,” which shall 1. State the responsibility of management for establishing and

maintaining an adequate internal control structure and procedures for financial reporting

2. Contain an assessment as of the end of the issuer’s fiscal year, of the effectiveness of the internal control structures and procedures of the issuer for financial reporting

Internal controls does not apply in some instances to small corp (where it is too expensive)

o Stone v. Ritter (Del 2006) Bank was complicit in setting up Ponzi scheme (someone brining in

money and just paying out money based on money brought in, no actual investment)

Bank Secrecy Act- bank was fined $50 million Is the board liable for paying the fine?

Is the board liable for an oversight compliance program that didn’t work?

Holding


Approving and studying Caremark, no “sustained or systematic” oversight failure since “reasonable” compliance program existed

o In re Citigroup (Del Ch. 2009) Citigroup bought subprime mortgages, caused $50 million in losses Was the board responsible for these losses?

Demand futility? How likely that directors are liable for not appreciating subprime risk?

Holding Applying Caremark, BJR teaches against highsight bias and for

informed risk-taking (ARM Committee- risk management committee existed)

o MBCA § 8.31- standards of liability Attempt to codify BJR No director personal liable unless

1. Challenged conduct not in good faith 2. Decision not reasonably believed best interests 3. Decision not informed in circumstances 4. Director’s lack of objectivity due to relationship/domination 5. Director’s sustained failure of director to be informed 6. Director’s receipt of financial benefit for which not entitled.


Chad Vanderhoef

Module 7A Notes Chapter 17

Nov. 13 Briefly Back to Close Corps

Oppression Doctrine - lack of liquid market for shareholders to escape o Defined by context of CHC

Minority shareholder can petition court for dissolutiono Statutory righto Business does not necessarily end -- majority often purchases assetso Share buyback may be initiated to avoid dissolution

Buyout is at fair value (determined by court if negotiation fails)o Fair market value v. Fair value

FMV = what would happen in arm's length transaction FV = no market; does not include discount for lack of control/marketability

In LLC context, operating agreement generally controlso Not in Haley because it was deemed unreasonable -- one member would have still been

personally liable for mortgage on restaurant

Shareholder Litigation Chapter looks at shareholder "sue" rights to enforce fiduciary duties Direct v. Derivative Actions

Derivative: 2 suits in 1 -- enforces fiduciary duties to corp. Direct: representative suit -- protects SH rights Distinction: Who recovers?

Demand Requirement

Board as arbiter of lawsuit's merits: Derivative suit is "bizarre" in that defendant has opportunity to permit continuation of suit

Aronson Test1. Director disinterest and independence2. Decision protected by BJR


Attorneys' fees are driver of derivative suit SH Self Protection

Voteo Approve fundamental transactionso Elect directorso Remove directors/fill vacancieso Initiate action (amend bylaws, adopt resolutions)

Sueo Enforce fiduciary duties (derivative suits)o Protect rights (disclosure, voting, appraisal, inspection)

Sello Liquidity (except insider trading)o Takeovers (tender offers)

Enforcement of Fiduciary Duties

Derivative Suit -- shareholder on behalf of corp.o 2 suits

SH v. Corp. Corp. v. 3rd Party

o Corp. is nominal defendanto Outside parties are rarely sued in derivative actiono Most suits are brought against directors or controlling SH o Remedy is to corp.o Attorneys are drivers of derivative actions

Fees are paid by corp. DE Supreme Court

o Rule 23.1 Retain ownership of shares throughout litigation Make pre-suit demand on board Obtain court approval of settlement

Class Actiono Direct action -- injury directly to SHo Attorneys are drivers of class actions as well

Lawyer would not take individual case -- not economicalo SH representative acts on behalf of SH classo Recovery to SHso Avoids demand requirement of derivative suit

Demand requirement = dismissal option Tooley v. Donaldson

o Minority SHs brought direct suit for breach of fiduciary duties as a result of postponement of merger

o DE Supreme Court wanted to clarify analysis of derivative v. directo Breach of fiduciary duty is alone insufficient to distinguish derivative and direct


o Old "special injury" standard unclearo New standard

1. Who suffered alleged harm -- corp. or individual SHs?2. Who receives recovery -- corp. or individual SHs?

o Court said suit is not derivative -- no injury to corp.o Court also said direct suit was not yet ripe

ALI Principleso Derivative =

Recovery to corp. Preclusive effect sparing corp. and defendants of multiple actions

Nov. 14 Derivative Direct

Corp. recovery Individual recovery

Corp. rights Rights of SH

Demand Class certification requirement

Settlement approved by court In DE, demand requirement kills derivative suit by putting decision in hands of board who then is protected by BJRMBCA absolutely requires demand Corporate SH is treated same as board in terms of fiduciary duty owed to other SHs Hypos (Direct or Derivative)

1. Direct - no injury to corporation by denial of preemptive rights; dilution is special injury to each SH

2. Derivative - corp. subsidiary harmed by parent; recovery to corp. sub3. Derivative - lifetime employment contract would result in recovery to corp.

a. Could also be direct if board decision was ultra viresb. Plaintiffs' attorney can manipulate litigation by characterization of suit

Demand Requirement

Rule 23.1 framed as procedural, but courts treat as substantive in defining relationship between Corp. and shareholders

Aronson v. Lewiso Plaintiff argues compensation to Fink is board violation of fiduciary duty owed to corp.


o TEST = Court said plaintiff must plead with particularity facts that create strong inference of reasonable doubt that:

Directors are independent and disinterested Transaction was product of valid exercise of BJR

o Stock ownership alone is insufficient proof of domination or control over boardo DGCL 141(a): Decisions regarding business and affairs of the organization are left to

board to manageo Decisions have presumption of validity under 141(a) = BJRo Where would you get particularized facts pre-discovery? DE inspection rights for SH

Board Dismissal

Derivative suit Special Litigation Committee formed to decide on merits

o Gets beyond 1st demand stage - demand futilityo Court should inquire into independence and good faith of committee and bases

supporting conclusionso Then court should balance corporate and shareholder interests

MBCAo SH must make demand -- cannot claim demand futilityo Time can be accelerated under certain circumstanceso Court shall dismiss when cleansed group -- such as SLC -- determines in good faith that

suit should not proceed

Nov. 15 2 approaches to demand requirement

1. Delaware SH faces choice of

Make demand on board: treated as concession that board is competent to make judgment

Direct suit Therefore, all suits are first brought to court without demand

Demand futility (Aronson) Actual claim

Board still creates SLC despite lack of demand SLC appears before court urging dismissal -- tough to accomplish because SLC created

by "tainted" board Was the composition process of SLC clean? Court exercises its own independent business judgment (Zapata) to decide of

litigation should proceed -- steps into shoes of board 2. MBCA

Demand is never excused -- must always make demand Wait 90 days for board review Then suit can be filed


Can petition for accelerated review If suit brought after board decision not to proceed, board can seek dismissal from court or

create SLC to appear on its behalf Court inquiry into independence of SLC (Einhorn)

Board Decision Making Business Judgment Rule

Procedural - how cases are supposed to come to court (demand requirement) Substantive - identifies what plaintiff must show to overcome presumption board is acting

properly Plaintiff bears burden to overcome presumption by showing bad faith, illegality, disloyalty, board

not informed Rule v. Doctrine

Rule = no director liability Doctrine = court will not question board's decision

Shlensky v. Wrigley Plaintiff argues negligence and arbitrary and capricious behavior Unlike other areas of law, BJR covers these acts absent fraud, illegality, conflict of

interest Court said directors can consider effect on surrounding neighborhood

Duties Tort law - reasonable person standard of care Admin - arbitrary and capricious

Justifications of BJR Protects risk takers that seek to maximize profit for shareholders

Kathryn Harvey


Chapter 20: Director Conflicts

A. The Big Picture 10 Trends Shaping Corporate Governance According to John Wilcoxa. Majority voting will become the norm, replacing the plurality vote standard

i. Means that each individual needs to get majority vote to sit on the board, rather than just simply top-vote getters will be on BOD

b. Executive compensation will be brought into line with enhanced disclosure (say on pay)c. Separating the role of chair and CEO (this actually kind of died)d. The model of the imperial CEO will be replaced by the stewardship model (hasn’t really

happened)e. Corporate social responsibility will be recognized as a key corporate responsibilityf. Shareholder communications and proxy votings will be revamped by the SEC to make

better use of technology (true, no new SEC rules but changes nonetheless)g. Shareholder resolutions will be overtaken by other forms of constructive engagement and

shareholder activism will become less confrontational (true and false in that shareholder proposals often withdrawn because accepted yet still vast majority rejected)

h. The definition of beneficial ownership will become more complicated (true, become increasingly complex and Palmiter thinks it will be simplified eventually)

i. Spotlight will shift from governance of companies to governance of institutional investors (true; there is an argument that even non-controlling institutional investors should have fiduciary duties to the people they control)

j. Companies will come to recognize that corporate governance is not a matter of regulatory compliance but instead a strategic goal (compliance in a way that is more than just checking boxes, but in a way that actually advances the business which seems to be happening)

B. Fiduciary duties reflect standard of care + when appropriate for judge to intervene.C. Duty of Loyalty cannot waive.

a. Compare BJR applied to transaction w/ outsider and lack of BJR when even just one direct conflicted.

b. Two pronged:i. Self-dealing:

1. Director on two sides of transaction with corporationa. Director can act in good faith + still have a conflict of interestb. Validity of t’sction will depend on fairness

2. Or, indirect interest self-dealing where corporate transaction is with another person or entity in which the director has a strong personal or financial interest

ii. Caremark claims (good faith duty of loyalty BOD’s duty to oversee corp’s activities to proactively prevent losses)

D. Possible Responses to T’sctions with Interested Director a. Flat prohibition

i. May not be a good idea what if entering into this t’sction is actually a good deal?

b. Shareholder ratification i. May not be a good idea Sholders basically do what BOD tells them and may

be uninformed, also expensive


c. Director ratification: T’sction valid if disinterested (no direct or indirect financial gain from t’sction), independent (not dominated by interested director), and informed (does not require that these BOD members know as much as the interested director) directors approve.

i. Better idead. Fair: Corp can enter into conflicting-interest transactions if a judge finds the transaction

was fairi. Fair hinges on whether corp would have enterered into t’sction absent COI

E. Once a challenger shows the existence of a director’s conflicting interesting in a t’sction burden on the party seeking to uphold the t’sction’s validity

a. Except under ALI and Subchapter F of MBCA challenger bears burden of proving t’sction’s invalidity when disinterested shareholders or BOD have approved t’sction

F. CL: Judicial Review of Interested Director Transactionsa. Void (l. 19th c.) Irrelevant if conflicted director avoided being involved in approving Kb. Process + substance (e. 20th c.) Unless majority of BOD disinterested and independent

+ fair, deal voided.c. Substance only (m. 20th c.) If fair, deal upheld.d. Modern CL – If majority of BOD disinterested and independent OR deal fair, deal

upheld. i. Substantive fairness review

ii. Procedural review of BOD’s decision-making process to measure whether approving directors are disinterested in transaction and independent of influence of the interested director

G. Traditional CL Approach (California): Judicial Intrusiona. Remillard Brick Co. v. Remillard-Dandini Co. substance only

i. F: Company makes bricks. Has to sell. Majority shareholders on BOD set up their own marketing sales company to which they sell the bricks. Minority shareholders of manufacturing company not okay with this because t’sctions b/t the two will favor the marketing company (b/c majority would rather send the $ to the marketing company that they own 100% of). Minority says these individuals breached their duty of loyalty by self-dealing. Stanley and Sturgis argued that they had informed all sholders + sholders approved the K, so no conflict of interest. Since Stanley and Sturgis were majority shareholders, vote approving contract was meaningless. Derivative suit.

ii. I: Did S+S breach duty of loyalty by engaging in a self-dealing t’sction where sholders were fully informed + approved K?

iii. H: Y. iv. R:

1. A transaction not automatically validated b/c disclosure and approval by majority of shareholders. Approval by majority of shareholders meaningless if interested individuals = majority shareholders. In this circumstance, some courts say need fully informed majority of the MINORITY to approve t’sction, while others say shifts burden of proof onto P to prove unfair (usually in COI situation, D/BOD member must prove fair).

a. “But neither section 820 of the Corporations Code nor any other provision of law automatically validates such transactions simply


because there has been a disclosure and approval by the majority of the stockholders. Even though the requirements of section 820 are technically met, transaction that are unfair and unreasonable to the corporation may be avoided. ... It would be a shocking concept of corporate morality to hold [otherwise].”

i. Judges decide morality.H. Interested-Director Statutes

a. Del. G. Corp. L. § 144 [edited a little] (a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable overruling common law solely for this reason if: (1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors [or](2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders [or](3) The transaction is fair as to the corporation as of the time it is approved.

i. This statute also in CA, where Remillard was. So why Remillard not okay?1. Statute says only requires “good faith . . . vote by shareholders.”2. Plain language rejected because will result in corruption. 3. This is allowed because in area of fiduciary duties, judicial rules

trump legislative rules.ii. Delaware cases

1. (Early approach) No safe harbor : Fliegler v. Lawrence (Del 1976): Compliance w/ statute doesn’t mean t’sction automatically valid court reviews t’sction’s fairness. Shifts burden to P if t’sction approved by BOTH disinterested BOD + shareholders

2. (Moving Towards Modern Approach) Safe harbor : Marciano v. Nakash (Del 1987) - "... (Dicta) Approval by fully-informed disinterested directors or disinterested stockholders means BJR applies (so burden on P).

3. (Modern approach) Safe harbor : Benihana of Tokyo v. Benihana, Inc (Del 2006):

a. F: BOT + its sub Benihana operated restaurants. Sub’s restaurants needed renovation but lacked funds. Sub decided to issue preferred stock to fund renovation and Abdo, on sub BOD, said financial company for which he served on BOD interested in buying stock. Abdo negotiated sale of stock on behalf of financial company. At sub meeting, Abdo made presentation on behalf of financial company regarding its proposed purchase of the stock. Sub BOD knew Abdo was director of financial company and were informed that Abdo had negotiated sale. Regardless, approved sale to BFC. Later, parent’s attorney asked sub board to abandon sale. Yet, BOD again approved sale. BOT then brought suit against sub BOD, alleging breach of fiduciary duties.

b. I: Is there a safe harbor for interested transactions where director’s conflict is disclosed and BOD in good faith authorizes

http://wwws.wfu.edu/~palmitar/CorpLawPolicy/Conexus/CorpIE_DelawareGenCorpLaw.pdf


t’sction?c. H: Yes. Will not look at substance of t’sction because DGCL

§ 144 provides safe harbor for interested transactions if material facts regarding COI revealed to BOD and BOD authorizes transaction by majority of disinterested directors.

i. After approval by disinterested directors or by shareholders BJR applies (burden on P).

iii. MBCA Subchapter F: Procedural Safe-Harbor

1.2. DCIT : T’sction by corporation in which director (1) is a party, (2) has a

material financial interest, or (3) knows that related person has material financial interest

a. Material financial interest reasonably expected to impair director’s judgment when authorizing the t’sction

b. Related person Enumerated familial relationship, someone who lives in director’s house, entity controlled by the director or someone on the family tree, entity on which director serves as director, partner, or trustee, or an entity controlled by director’s employer

i. Family relationship : (i) the spouse (or a parent or sibling thereof) of the director or a child, grandchild, sibling, parent (or spouse of any thereof) of the director, or an individual have the same home as the director

1. If you don’t meet this definition, no DCIT.2. CL would look at this more contextually.

c. If you are outside of this definition YOU’RE FINE. Regular BJR review.

3. BOD approvala. Director “qualified” disinterested + not controlled by

conflicted directori. Director not unqualified b/c nominated or elected to

BOD by conflicted director or serves with conflicted director on board of another corp


ii. Approval by qualified directors need majority (relaxed quorum if you have a majority you’ve satisfied) (meeting these standards can have no fewer than 2)

b. Qualified directors must vote outside the presence of and without the participation by any other non-qualified director strict voting

c. Received required disclosure regarding facts that an ordinarily prudent person would reasonably believe to be material

d. Court will still review regarding whether manifestly unreasonable to corporation

4. Sholder approvala. Disinterested; andb. Approved after requisite notice + disclosure of conflictc. Need majority of disinterested shares (not shareholders) to

constitute a quorumd. No substantive review whatsoever

i. No further review even if waste5. Fairness

a. Reasonable price; andb. T’sction benefits corpc. Has to be negotiated in a fair way (can’t be one-sided, screwy)d. BOP on D (If don’t have process, D has to show t’sction fair)

6. Bright line but may miss certain conflictsa. Why not all MBCA states have adopted this provision

7. Quiza. B owns Blackacre and also sits on the board of Corp X. If B

sells Blackacre to X, the transaction is director self-dealing.b. B’s sale to Corp X is: (depends on when and where you are)

i. MBCA states (not all have even adopted subchapter F)

ii. Modern Delaware – okay if approved by disinterested or informed BOD or majority of disinterested informed shareholders / okay if judge determines to be fair (best answer b/c informed and disinterested left out on slides)

c. Fairness meansi. Transaction is good for corporation (receiving a

benefit) + transaction reflects fair market price / terms (2 fold inquiry)

ii. Don’t demand self-interested director to reveal his “reservation price”

d. In shareholder suit challenging B’s sale of Blackacrei. Burden typically on person trying to justify the

t’sction should be good (interested director)ii. Need to show fairness or proper approval

e. DGCL § 144 i. Applies BJR if defendant shows proper board


approvalf. When Benihana Inc raised capital from director, Del. Sup.

Ct. said DGCL § 144 provided safe harbor since qualified directors OK’d deal.

i. Benihana very impt. caseg. Under DGCL § 144

i. BJR applies if DCIT approved by informed directorsii. BJR applies if DCIT approved by disinterested

directorsiii. BJR applies if DCIT approved by independent

directorsh. MBCA Subchapter F

i. Covers all situations of DCITii. Interested director cannot be part of the deliberation

for there to be proper board approval – not true in DE

I. Board Approval, Sholder Approval, and Fairnessa. Board “Cleansing”: Approval by Disinterested + Independent Directors

i. This type approval relevant where1. Board reviews DCIT2. Where Board reviews shareholder demand (Disney)3. SLC reviews shareholder lawsuit (Oracle)

ii. Interested:1. “… directors can neither appear on both sides of a transaction”; or2. nor expect to derive any personal financial benefit from it in the sense

of self- dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally."

a. Ex: Your salary depends on this t’sction going throughi. Not sufficient you’ll make new friends if this t’sction

goes throughb. Corporate statutes make clear directors w/ financial interest are

“interested” but usually do not address non-financial relationships that will call into question approval by a director

iii. Independence:1. “… [A] director's decision is based on the corporate merits of the subject

before the board rather than extraneous considerations or influences.“ Plaintiff must show particularized facts manifesting 'a direction of corporate conduct in such a way as to comport with the wishes or interests of … persons doing the controlling.”

a. Federal law requires certain degree of independence, but state law more clear

b. Difference between SLC / Demand Independence “Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar’s wife” -- above reproach.”

i. Takeaway from below : Not one monolithic standard


regarding independence b/t all of these different areas of the law

ii. Independence in SLC context (more sensitive standard)

1. Oracle Corp. Derivative Litigation: Oracle sholders brought derivative suit claiming company insiders knew December 2001 earnings would fall short of expectations, so they sold their stock – insider trading. Oracle BOD created “special litigation committee” composed of two eminent Stanford professors who said suit should be dismissed. Came out that Stanford professors being asked to investigate Oral directors with important ties to Stanford serve w/ SLC member on research institute, one BOD contributed millions of dollars to Stanford, etc. DENIED SLC’s recommendation.

iii. Independence in Demand Context (less sensitive standard)

1. Martha Stewart Living Omnimedia, Inc. v. Stewart – Amenable to broader concept of director independence (including social relationships; usually excluded by court), but will not overcome presumption that directors independent without specific evidence of bias (which is not created by social interactions)

a. Rejects here because the mere argument that structural bias exists insufficient need specific facts to properly allege

i. B/c you’ll have this in basically every BOD

b. “Allegations that Martha Stewart and the other directors moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as “friends” even when couple with Stewart’s 94% voting power, are insufficient without more, to rebut the presumption of independence.”

iv. Charles Elson – structural bias is real; to combat, compensate w/ stock

b. Disinterested Shareholder Approvali. Ratification (after the fact sholder approval of COI t’sction)

ii. Lewis v. Vogelstein


1. F: Mattel BOD gives themselves stock options (non-binding opportunity to buy stock from company at defined price (which may not be back-dated b/c this guarantees additional profit and is fraud under SEC) after vesting period closes and before period expires – you'd only exercise the option if the price you can buy is less than mkt price (in money, as compared to out of money), so you can turn around and sell for profit).Obviously COI, so BOD asks for shareholder ratification to approve. Some shareholders brought derivative lawsuit against BOD for breach of duty of loyalty because stock plan excessive. BOD argued that plan ratified by sholders so it must be fair.

2. I: How much weight should we give to ratification by informed shareholders?

3. H: a. Ratification not a complete defense because shareholders

cannot negotiate.i. Court identifies problems w/ ratification

1. Inability to negotiate – “take it or leave”2. Collective action problems

b. Ratification shifts burden to P to prove waste (no consideration). Safety valve.

i. Here, stock options so unusual to be considered corporate waste motion to dismiss denied.

c. Collective action problems even with institutional shareholders.

iii. Harbor Financial Partners v. Huizenga1. BOD of Republic solicited proxy statement to sholders to approval

acquisition of another corp. Sholders approved. BOD owned stock at other corp and made lots of $ from acquisition. Sholders brought derivative lawsuit against directors for breach of fiduciary duty. BOD said since acquisition approved by sholders could not have been unfair. Sholders argued proxy solicitation was materially misleading (not fully informed), so vote shouldn’t immunize BOD.

2. I: T’sction valid?3. H: Yes. Where vote on acquisition informed, uncoerced, and by

disinterested shares BJR applies and P can only prevail by proving unfairness or waste (not proven here).

a. Court questioned if there was even a need for the corporate waste "safety valve." In Court's opinion, if there was a fully informed, uncoerced vote of disinterested shareholders there is strong evidence of fair exchange which seems like it can’t meet the very high bar for corporate waste. To hold otherwise assumes “presumes stockholders are, as a class, irrational and that they will rubber stamp outrageous transactions.”

4. Summation : Sensitive if there is shareholder ratification whether there is further review. Under MBCA, if shareholder ratification (informed, uncoerced, disinterested, independent) that’s it. No further review.


c. Entire Fairness (determined by court)i. Requires analysis of two forms of fairness:

1. Substantive whether the proposition submitted would have been attractive (based on terms (most importantly price), benefit to corporation, and process of decision making) an independent corporation

a. If substantively fair, will usually be upheld2. Procedural focuses on internal corporate process followed in

obtaining approval by directors or sholders (disclosure to BOD, composition of BOD that approved t’sction, role of interested director in t’sctions initiation, negotiation, and approval)

J. Corporate Opportunity Doctrinea. Corporate opportunity doctrine : Cannot usurp a business opportunity where the

corporation has an interest in the opportunity (including expectancy in the opportunity) or it is within the corporation’s line of business, unless corporation could not finance the t’sction itself (not clear if element of corporate opportunity or defense) or corporation (BOD or possibly shareholder apply ratification standards) has rejected the opportunity.

i. Remedy : Impose constructive trust; give corp what they would have gotten without the usurper’s action (in Farber includes both sale of land + profits from it).

b. Farber v. Servan Land Co.i. Serianni and Servin on BOD of Servan + majority shareholders of the

corporation. Land next to Servan on market (looks like S+S found out abt this from seller based on their capacity as BOD, assumption they might be interested in purchased for expansion purchases). BOD considered buying at shareholder meeting but took no action. Later, Serianni and Servin bought land in individual capacities. Did not bring this up to BOD until pressed by dissenting sholder. Serianni and Servin told BOD and had a vote ratifying. 3 years later, Servan liquidated and entered into agreement w/ Serianni and Servin to sell both parcels of land to 3P. Farber, a Servan shareholder, brought a derivative lawsuit against Serianni and Servin for breach of the duty of loyalty. Farber argued that buying the parcel of land was taking of a corporate opportunity.

ii. I: Standard for taking of corporate opportunity? iii. H: Corporate opportunity applied; no rejection occurred.iv. R:

a. Court articulates both expectancy and line of business testb. Applies expectancy testc. Not clear if the fiduciary must have offered the opportunity to the

corporationd. Not clear what constitutes corporate rejection / ratificatione. Remedy = corporate trust

c. Burg v. Horn i. CHC / slumlord. 1/3 and 2/3 owners. 2/3 owners (Horns) also run other

businesses and have other interests in similar businesses to this one (other slumlord businesses). Court says won’t force sharing of those opportunities and profits because when the 1/3 owner got involved in the corporation knew that the 2/3 had these other interests + did not contract for any protection. No usurpation


of corporate opportunity by informal acquiescence by virtue of the knowledge from the beginning that the 2/3 owner had these interests.

1. Maybe different corporate opportunity test in CHCd. Corporate Opportunity Tests

i. Tests are default so corporate participants can waive1. Ex: DGCL § 122: Every corporation created under this chapter shall

have power to – (17) Renounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in, or in being offered an opportunity to participate in, specified business opportunities or specified classes or categories of business opportunities that are presented to the corporation or one of more of its officers, directors, or stockholders.

2. Majoritarian default rule (naturally assume that fiduciaries are your agents and have responsibilities not go out and undermine the business).

ii. Competing Spheres 1. Corporate expansion sphere v. entrepreneurship

a. If corporation has contractual or property interest fiduciary must abide by that corporate interest.

i. Couldn’t use corporate assets to pursueii. Couldn’t jump in if corporation has a contract and take

that oppb. Expectations – Corporation simply expecting an opportunity

i. May be inferred or in business planii. Corporate law protects

c. Line of businessd. BUT if the corporation cannot finance this – even though it

signed a K – wipes out the potential.2. Entrepreneur

a. “I’m willing to be on the BOD, but I want to be able to pursue my business interests that may align with the corp’s.”

b. “Every corporation has the power to renounce, in its certificate of incorporation or by action of its BOD, any interest or expectancy of the corporation in specified business opportunity that are presented to the corporation.”

i. So can put in AIC or BOD can approve3. Insides of corporation can renounce / reject corporation’s interest.

a. Maybe acquiescence rises to the level of rejection or renunciation

4. Is it fair to limit the fiduciary in their entrepreneurial interests?iii. Approaches to Definition of Corporate Opportunity

1. Traditional - Focus on corporationa. “Expectancy” Corporate opportunities not limited to actual

ownership and include interests or expectancies, narroweri. Ex: Corp negotiating new business, exec learns of

business opportunity directed to corp, corp’s avowed interested in finding new headquarters or a new parent


corpii. Knowledge requirement usurper must know of

interest/expecb. “Line of business” Corporate opportunities include

opportunities consistent with current or anticipated operations + that corporation could afford to take on, broader

i. Additional Factors/Tests that may be considered in addition to those above

1. “Ability to finance” Some courts will consider while others won’t (factor, not test some courts will consider)

2. Fairness was it fair and ethical for BOD to take this opportunity? (added in addition to other tests in some courts)

c. These standards reflect a balance b/t focus on corp and focus on fiduciary

i. Rejection (implied)ii. Acquiescence

2. Procedure - ALI Principlesa. Codify duties of directors, executive, b. Must present to BOD, shareholders independent objective

decision-maker + must be full disclosure)c. No acquiesenced. Different levels: directors vs. executive officers

i. Director - Offeror expects to corporation; Fiduciary expects corporate interest

ii. Executive officer - Offeror expects to corporation; Fiduciary expects corporate interest + Fiduciary aware corporate opportunity closely related to actual/expec business of corporation

e. Requires presentation of offer to corp + disclosure of conflict of interest + corporate opportunity

f. Requires Mandatory formal rejection by disinterested directors, shareholders, court

g. §5.05 Taking of Corporate Opportunities by Directors Senior Executives (a) General Rule. A director or senior executive may not take advantage of a corporate opportunity unless: the director or senior executive first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate opportunity; the corporate opportunity is rejected by the corporation; and (A) the rejection of the opportunity is fair to the corporation; or (B) the rejection is authorized in advance following such disclosure, by disinterested directors, or, in the case of a senior executive who is not a director, authorized in advance by a disinterested superior, in a manner that satisfies the standards of


the business judgment rule; or (C) the rejection is authorized in advance or ratified following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corporate assets.

h. (b) Definition of a Corporate Opportunity. For purposes of this Section, a corporate opportunity means: (1) any opportunity to engage in a business activity of which a director or senior executive becomes aware, either: (A) in connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or (B) through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or(2) any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage


Tom Watkins

December 3, 2012631-649

Self-dealing transactionsDirector on both sides of the dealUsed to be void

Used to consider procedure and substanceNow just substance

Common director/significant shareholder may use his influence over one company to disadvantage that company and benefit another company he is similarly involved with

ApproachesFlat prohibition

Cannot enter into transaction regardless of other factorsShareholder ratification

Okay, as long as other shareholders validate transactionIndependentInformedDisinterested

Director ratificationOkay, as long as other directors of corporation validate

IndependentDisinterested

FairCorporation can enter into conflicting-interest transactions if a judge finds the transaction was fair

Judicial Review – EvolutionCommon Law – Procedure and SubstanceEvolving Common Law – Substance onlyModern Common Law – Procedure or Substance

Remillard Brick Co. v. Remillard Dandini Co.Brick business/companyStanley and Sturgis owned a majority of Brick Corp.Also owned all of Sales Corp., which contracted with Brick Corp. to sell bricks


DGCL § 144(a) No transaction between a corporation and any other corporation in which its directors

have a financial interest, shall be void or voidable solely for this reason if:(1) The material facts are disclosed and the board authorizes the transaction by the

affirmative votes of a majority of disinterested directors(2) The material facts are disclosed to the shareholders and the transaction is

approved in good faith by vote of the shareholders(3) The transaction is fair as to the corporation as of the time it is approved

California Appeals Court“But neither section 820 of the Corporations Code nor any other provision of law automatically validates such transactions simply because there has been a disclosure and approval by the majority of the stockholders”

“Even though the requirements of section 820 are technically met, transactions that are unfair and unreasonable to the corporation may be avoided... it would be a shocking concept of corporate morality to hold otherwise”

December 4, 2012649-667

Fiduciary Duties – Standard by which judges will intervene and substitute its own judgment and will on the board

Ways corporate law deals with conflictBecome more and more liberal, accepting and letting be decisions that one might think the court should have stepped in onLeave it to the control measures put in place by corporation

Fliegler v. Lawrence (1976)DGCL 144 merely removes an interested director cloud when its terms are met. Nothing in the statute removes the transaction from judicial review

Marciano v. Nakash (1987)Moving from substantive review to procedural review

Benihana of Tokyo v. Benihana, Inc. (2006)If you comply with “Safe Harbor,” you are okay

Relationship or interest disclosedBoard authorizes the transaction (in good faith)

Majority of disinterested directorsProvides a safe harbor for interested transactions, like this one, if the material facts as to the director’s relationship or interest and as to the transaction are disclosed or are known to the board of directors and the board in good faith authorizes the transaction by the


affirmative votes of a majority of disinterested directors

Hypothetical (Fred – Selling Blackacre to Corporation XYZ)

MBCA - “Related Person”Spouse (or a parent or sibling thereof) of the director, or a child, grandchild, sibling, parent (or spouse of any thereof) of the director, or an individual having the same home as the director

Cousin does not fall under this definitionUnder common law, the court would likely do a more fact specific inquiry

Subchapter FDoes it fit definition? (if yes) Does it fit into Safe Harbor (if no)

Board Approval - Did the Board authorize/approveRequired disclosureReview “manifest unfavorable”

New version of MCBA – Manifest unfavorable standard does not appear anymore

SH ActionNotice and required disclosureReview: no substance

Waste – no reasonable person would say that the corporation has received consideration for the transaction

“Fair” (Note)Review: Tax termsReview: Corporate benefitsThe burden of proof is on the DefendantSubstantive and Procedural aspect

Pop Quiz1) Correct Answer: B – Director Self-dealing

Insider TradingBuying or selling stock on the open market with privileged information

Usurpation of Corporate OpportunityBoard Member takes opportunity for other/personal benefits while depriving the company of the opportunity


2) Correct Answer: D – Okay, if judge determines it to be “fair”

Other answer choices have slight defects and omissions

3) Correct Answer: A – Transaction is good for corporation

Identify that there will be a benefit to this corporation/businessThen look at the price and terms (Fair market value analysis)

What a reasonable person would accept in marketplace

4) Correct Answer:

Burden is typically on the person/thing trying to validate the alleged self-serving transaction

5) Correct Answer: CBenihana

6) Correct Answer: CBenihana

7) Correct Answer: A, B, CAll of the above

8) Correct Answer: AFairness review only if the other ones do not applyStill is some judicial scrutiny

Still makes sure the directors are doing what they are supposed to be doing: asking questions, reviewing documents, etc.

MBCA – interested director cannot be part of the approval deliberations

Board CleansingCourts in Delaware are willing to be completely hands off when the directors are disinterested and independent

Contexts (Disinterested and Independent)Board Reviews DCITBoard Reviews SH DemandSLC Reviews SH Lawsuit

Martha Steward Case


Court says that the bias or “taint” of an interested board member of the rest of the board must be proven/shown with facts

Should there be more inquiry into when constructive bias rises to the level of “interested” in an SLC case?

SLC case (Oracle) – YesPossibly the facts are different and the standard is the same

Charles Elson – Delaware Center Corporate GovernanceStructural bias is real and cannot really be overcomeCompensate directors only with stock – endowment effect

December 5, 2012667-679

Midterm becomes available Thursday at NoonDue Friday at Noon

Shareholder Ratification*Life Lesson* Read statutes

Lewis v. Vogelstein (1997)Stock Option: Non-binding opportunity that gives the recipient (usually a director) the ability to buy from the company in the future shares of stock at a fixed price (usually the price of the stock when the stock options are granted/gifted

Often, there is a vesting periodAt some point, the stock option expiresSpecified at the point they are granted

Using Back-date: Securities FraudGranting stock options at a price point from the past(Know “back-date” term)

Issue: How much weight should we give SH ratification?1) Complete defense2) Shift burden to P to show waste3) Shift burden to P to show unfairness4) No effect

Problems with ratificationInability to negotiate (Take it or leave it policy)Collective action problems


Standard – SH ratification shifts burden to P to show wasteMust show that the consideration was so disproportionately small as to lie beyond range at which any reasonable person might be willing to tradeSuch a transfer is in effect a gift

Safety Valve – ReviewHarbor Finance Partners v. Huizenga (1999)

Questions Safety Valve application

You should be sensitive with SH ratificationThere should be further reviewShould be

UncoercedDisinterested

Corporate OpportunitiesIf you are an executive director

Held to not taking the company’s business opportunitiesBack to independent, disinterested approval standard

Competing SpheresCorporate law wants to give businesses and SH the hope that their business can and will expand

On the other hand, expansion can happen through entrepreneurship

How do we juxtapose these values?

Corporate Expansion PotentialIf the corporation has a contractual or property interest, then the fiduciary must abide by that corporate interestIf corporation is just expecting to expand (actual or inferred), corporate law protects – but a little less rigidIf the opportunity is in the same line of business, still more flexible

Inability to finance – corporation does not have that potentialWiped out conflict/controversy

Entrepreneurial InterestsYou can waive these fiduciary duties by board approval or through the articles of incorporation provisions


RejectionAcquiescenceFairness

Approaches – Corporate OpportunityTraditional – Focus on corporation

ExpectancyLine of BusinessInability to finance

Balance – Focus on fiduciaryRejection (implied)Acquiescence

Farber v. Servan Land Co. (1981)Corporation – Golf CourseBoard – 2 members on the board were majority shareholdersA quarter of a square mile of land goes on the market

Closed corporationDirectors talk about possibility of acquiring land at meeting

You cannot usurp a business opportunity for yourself if the corporation has an interest/expectancy in the opportunity or is in the same line of business as the opportunity unless the corporation could not finance it itself or if it was rejected by the company (SH or independent, disinterested, informed directors)

Board did not take action one way or the other on the opportunityAs individuals, the 2 board members buy the land on their own

Disclosed it at the next SH meetingAnother board member has found out about it in the interim

Farber brings derivative suit – wants the corporation to get this opportunity, not wanting to get the opportunity himself

You get what you would have gotten had the corporation been allowed to take the opportunity (Constructive Trust)Purchase is being held in Trust for the corporation

Must turn over their profits to corporation

Applies expectancy testSome of the finer details are not completely clear

Whether corporation had to be explicitly offered dealWhat constitutes rejection and ratification


Tailored Rule (likely)Holding – Corporate opportunity applies here

There was no rejectionMust be sharedRemanded for district court to determine how to share the profits

Burg v. Horn – HypotheticalBurg owns 1/3Horn owns 2/3Horn also owns other interests

Court says that those other interests will not be shared because Burg, when entering into the business, knew that the Horns had other interests going onThere was informal acquiescence by virtue of the knowledge of the minority shareholder that the majority shareholder had other interests

More fluid way of looking at the situationIn closed corporations, there may be a different standard


Ben Zich

- Board decision Making

o BJR 2 prongs:

Procedural Substantive

o Conflict of interesto Illegalo Fraudo Wasteo Inattentive-

Standard in DGCL is gross neg.- Smith v. Van Gorkam

o Nagging tax problem Not sufficient capital income

Too much of a good thing: Trans Uiont has more depreciation than it can use. Company can’t use investment tax credits since it doesn’t have enough taxable income to offset them.

o Options Get congress to pay for unused tax credits Acquire biz to generate tax. Income Sell to public or private corp that wants tax benefit Sell In mgmt. buyout (mgmt. borrows to buy corp)- doesn’t create taxable

income An MBO would make for even more deductins


o Board Meeting: Offer

Offer to sell $55/share = 50% premium over trading price 62% better than the average of high and low prices for yr

Time pressure Have to make a decision by Sunday evening

No shop clause Can’t shop the company to others, but can see what market thinks

of $55 and receive offers during a 3-month test periodo BOD composed of supremely qualified individualso What went wrong w/ deal

Could they have realized more? Got a great deal but why was Pritzker willing to pay so much?

What about a bidding war? Why does it ned to be done so quickly? Why didn’t board ask important question before taking the deal BOD didn’t inform hemselves as to Van Gorkam’s role in deal Didn’t inform themselves of

Van Gorkam’s role in sale Value of company Details of deal

There was gross negligence Didn’t inform themselves of

Van Gorkam’s role in sale Value of company Details of deal

BJR deference to Bd: Premium was a great price and great time to sell GE Capital and KKR showed interest but backed off, so good price Collective experience of BOD was high Boston Consulting said Trans Union = $55

- Group question- what did the Van Gorkom case mean?o Answers by groups

Judicial second guessing New board procedures


New role for outside directors Court reacts to “fast shuffle”

DE is acting in a way that no other state does (finds no precedent in DE

law) o Recommendations by groups

Do nothing- let DE courts fashion director liability rules Codify VG- directors liable for gross negligence Overturn VG- directors not liable for gross negligence- BJR New law- higher standard of independence and reasonableness New law- director liability depends on level of participation New law- safe harbor for following boardroom process New law- directors (SHs) can contract for exculpation

- Standards of Reviewo Procedural: gross negligence

Importance of posturing Procedural helps assure substance

o Substantive: wasteo Causation

Inattention proximate cause of loss Who bears the burden of proof

- Avoiding director liability o Individual directors are rarely personally liable for Duty of Care violations, even

after Van Gorken. The four legged stool protecting directors

Proximate cause and BJR Exculpation clause Indemnification D&O (director & officer) insurance

- James J. Hanks: leading practitioner on director liability avoidance:o "Notion in the history of development of corporations or corporation law suggests

that the personal assets of directors were intended to constitute a financial safety net for stockholder or others willing to second-guess director's decisions."

True or False? FALSE: Bank directors were held personally liable for bank failure before Federal Deposit Insurance


o BJR and Causation o Remember Trans Union: Even if the directors had been

properly attentive would they have necessarily gotten a better price? Unclear that that would have happened

o Must show proximate cuase What’s the harm they caused?

- What's the harm they caused?o Barnes v. Andrews (SDNY 1924): Judge Learned Hand: "Who knows what the

manager could have done? Even though he violated his duty, you can't prove he caused any harm."

Francis v. United Jersey Bank (NJ 1981): Mrs. Pritchard neglected her duty of care, but we won't hold her liable unless we can find something that she should have done but failed to do. Here, she could have done all these things and thus liable.

o Statutory Exculpation Statutory Authorization

Delaware GCL 102(b)(7): Contents of certificate of incorporation o (b) . the certificate of incorporation may also contain . o (7) A provision eliminating or limiting the personal liability

of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, ... provided that such provision shall not eliminate or limit the liability of a director:

(i) For any breach of the director's duty of loyalty to the corporation or its stockholders;

(ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;

(iii) under 174 of this title; or (iv) for any transaction from which the director

derived an improper personal benefit. Trans Union had no Effect on

1. Leg 3:Indemnification a. NCBCA Mandatory Indemnification: Right

1. Unless limited by its articles of incorporation, a corporation shall indemnify a director who was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he was a party because he is or was a director of the corporation against reasonable expenses incurred by him in


connection with the proceeding.a. Successful Defense; Whole or Partial Success?

i. Mandatory indemnification of reasonable expenses incurred by him in connection with a successful defense

ii. Must be wholly successful on merits or otherwise in his defense

b. Permissive Indemnification: You may1. A corporation may indemnify an individual made a party to a

proceeding because he is or was a director against liability incurred in the proceeding if:

a. He conducted himself in good faith; and b. He reasonably believed ... that his conduct was in [the

corporation's] best interests ...2. Standard of Conduct

a. Must have conducted himself in good faith and reasonably believed he was acting in corp's best interests

b. In other words, can't violate Duty of Care or Duty of Loyalty

c. Derivative Litigation?1. : Authority to indemnify (LIMITS)

a. A corporation may not indemnify a director under this section:

i. In connection with a proceeding by or in the right of the corporation in which the director was adjudged liable to the corporation;

2. Forbids indemnification of director in derivative suita. A Derivative Suit is filed by SHs "on behalf of corporation"

to hold Board liable.i. So, to indemnify for judgments against board would

be circular b/c P would be paying the D.ii. But can get litigation expenses if approved by:

Majority of disinterested directors (perhaps brought in for that purpose) and

iii. majority of disinterested SH2. Leg 4: Directors' and Officers' Insurance

a. A corporation may purchase and maintain insurance on behalf of an individual who is or was a director ... against liability asserted against or incurred by him in that capacity or arising from his status as a director ... whether or not the corporation would have power to indemnify him against the same liability under any provision of this Chapter.


Board Oversight

3. Supervision of Ongoing Business i. Aspirations v. Reality: Prof. Mel Eisenberg (Sr. statesman of academic business

law)a. "A standard of conduct states how should play role. A standard of review

states whether court should impose liability."b. In the real world, standards of review in corporate law pervasively diverge

from standards of conduct.ii. Francis v. United Jersey Bank (1981)

a. What is reinsurance? Insurance companies pass their risk on to the reinsurance company

1. Facts:a. Pritchard & Baird Corp is in reinsurance brokerage

business -- and the company handles a lot of money. Assume you are a director of the company.

b. William Pritchard Sr. founded company, but after he dies his two sons (William & Charles) run business into the ground. Steal $10 million of clients' money, covering up their defalcations as "loans" in company's financial statements.

c. Mrs. Pritchard "became incapacitated and was bedridden [and] became listless and ... started to drink rather heavily." She did not attend meetings of the board of directors "never knew what her sons were doing ..."

2. Holding:a. "Her neglect of duty contributed to the climate of

corruption; her failure to act contributed to the continuation of that corruption. Consequently, her conduct was a substantial factor contributing to the loss.

b. "Sometimes ... a director may have a duty to take reasonable means to prevent illegal conduct by co-directors; in an appropriate case, this may include threat of suit."

c. Plus, who gets her estate? The sons. So who are we really punishing here? The sons, the two culprits in the case.

d. So, keep in mind this is a very unusual case - may not apply in all cases-Causation is big here.

4. Monitoring of Legal Compliance and Controls i. Graham v. Allis-Chalmers Manufacturing (Del. 1963)

a. Facts:1. Allis-Chalmers, (electrical equipment mfr.), wondrous multi-tiered

bureaucracy. Its employees, under pressure to make profits,


conspire to fix prices. Big case: first one where white-collar employees went to jail under anti-trust statutes.

2. This case examines whether directors violated a duty to monitor the company

3. You are a director of Allis-Chalmers. What must you do to ensure legal compliance?

a. It is entirely reasonable to transfer these decisions to lowest-level. Board does not have to oversee price-setting policy. They don't have to monitor unless they had notice - were their danger signals

b. Holding: board does not have to institute a monitoring system, just respond when there is a red flag

1. ". that in 1937 the company had consented to the entry of [antitrust] decrees ... did not put the Board on notice"

2. "There is no duty upon the directors to install an operate a corporate system of espionage ."

3. "Only if he has "recklessly reposed confidence in an obviously untrustworthy employee. Or has ignored . obvious danger signals"

4. From a SH wealth-maximization standpoint, this is great!ii. If a person drives 167 mph in a 50 mph, we don't fine the passenger, or the person

who gave them the car. At some point, the thrill of going that speed overcomes a fine.

a. Why care if board, acting to max SH profits, violates law? Why force the board to act if they know of illegal actions.

5. U.S. Sentencing Guidelines reduce sentences for corps that have internal controls.i. In re Caremark International Inc. Derivative Litigation (Del. 1996)

a. Facts:1. Caremark, a health-care provider, engages in referral kickbacks.

Illegal under Medicare and Medicaid. Regulators and private payors sue and Caremark agrees to compliance measures and pays $250M

2. You are a Caremark director. Are you liable for not having internal controls?

3. Holding: Yes. You must have an internal monitoring, but BJR for responding to it.

a. "... corporate boards may satisfy their obligation to be reasonably informed concerning the corporation [by] assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and the board itself timely, accurate information sufficient to allow management and the board .... to reach informed judgment concerning both the corporation's compliance with law and its business


performance.b. What changed from Allis-Chalmers?

1963: Unless somebody is hitting you over the head w/ a 2x4 of notice of illegal action, you don't have to do anything.

1996: You need a system to identify the illegal action, but BJR for responsec. Boards must be informed: Greater focus on corporate

responsibilityb. U.S. Sentencing Guidelines: Must comply w/ law. Must also set up

internal controls to show you attempted to comply6. So, when are Directors Liable

i. Is "stupid, egregious, and irrational" enough?a. Judge Learned Hand: "True, he was not very suited to the job, but I

cannot hold him on that account. After all it is the same corporation that chose him that now seeks to charge him."

1. "Must a director guarantee that his judgment is good?"a. Caremark framework: "Plaintiffs would have to show:

Either: (1) that the directors knew; OR (2) should have known that violations of law were occurring [sustained and systematic failure]; AND In either event: (3) that the directors took no steps in good faith effort to prevent or remedy that situation; AND (4) that [defendants do not establish affirmative defense] that such failure [did not] proximately result in the losses complained . . ."

7. Director's Criminal Liability i. Rule: Directors better than courts at making business judgments. Thus,

directors not second guessed in business decisionsii. Doctrine: Directors not held liable for poor decisions as long as reasonably

believe it to be in best interests of corporation.a. The Plaintiff has the burden of proving the decision was illegal,

fraudulent, self-dealing / conflict of interest, or so irrational that there is no basis for it and it must be one of these other things.

iii. Sarbanes-Oxley § 404 (2002)a. Requires that a corp in its annual report to contain an “internal

control report,” which shall 1. 1. State the responsibility of management for establishing and

maintaining an adequate internal control structure and procedures for financial reporting

2. 2. Contain an assessment as of the end of the issuer’s fiscal year, of the effectiveness of the internal control structures and procedures of the issuer for financial reporting


b. Internal controls does not apply in some instances to small corp (where it is too expensive)

iv. Stone v. Ritter (Del 2006)a. Bank was complicit in setting up Ponzi scheme (someone brining in

money and just paying out money based on money brought in, no actual investment)

b. Bank Secrecy Act- bank was fined $50 million c. Is the board liable for paying the fine?

1. Is the board liable for an oversight compliance program that didn’t work?

d. Holding1. Approving and studying Caremark, no “sustained or

systematic” oversight failure since “reasonable” compliance program existed

v. In re Citigroup (Del Ch. 2009)a. Citigroup bought subprime mortgages, caused $50 million in losses b. Was the board responsible for these losses?

1. Demand futility? How likely that directors are liable for not appreciating subprime risk?

c. Holding1. Applying Caremark, BJR teaches against highsight bias and for

informed risk-taking (ARM Committee- risk management committee existed)

vi. MBCA § 8.31- standards of liability a. Attempt to codify BJRb. No director personal liable unless

1. Challenged conduct not in good faith

2. Decision not reasonably believed best interests

3. Decision not informed in circumstances

4. Director’s lack of objectivity due to relationship/domination

5. Director’s sustained failure of director to be informed


6. Director’s receipt of financial benefit for which not entitled.

chapter 17: sh litigation - wake forest...

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